There has been a lot of talk recently about private accounts as a solution to Social Security's long-range financing problems. I am going to make two very important points in this column about this issue. First, you must understand the difference between "carve-out" and "add-on" plans when you hear politicians touting such proposals. Second, these plans -- although they may have merit for other reasons -- would do NOTHING to solve Social Security's long-range financing problems.
Many readers have written asking me questions about plans to "privatize" Social Security. You probably won't find many politicians using that term anymore. Ever since the financial collapse a few years ago, saying you want to turn Social Security over to Wall Street brokers (i.e., to "privatize" Social Security in the traditional sense of the term) is like saying you want some monkeys with a dartboard to make financial decisions about our nation's primary means of supporting older folks in retirement.
But you will hear lots of people talking about using "private accounts" or "managed accounts" to supplement future Social Security benefits. Most of these plans are NOT pegged at current retirees or even at baby boomers nearing retirement, but instead at workers who are younger than 40.
And when you hear talk of such proposals, please remember to ask this question: Is it a "carve-out" plan or an "add-on" plan? There is a huge difference.
Both plans involve requiring younger workers to contribute money to an IRA-type account that would offer several investment options. The worker could choose a safe but generally low-yielding account or a riskier but potentially more rewarding one. The investments from this account would then be used to augment Social Security retirement benefits.
But the difference lies in the funding details. In a carve-out plan, the worker's individual retirement account investment would be funded with a portion of his or her Social Security payroll tax. For example, currently 6.2 percent of a worker's salary is deducted for Social Security taxes. A carve-out plan might specify that 4.2 percent continue to be used to fund Social Security, while 2 percent would be funneled into the private account. In other words, this plan gets its funding by carving it out of the current Social Security system.
On the other hand, an "add-on" plan would require a worker to contribute an extra amount to fund the private account investments. So 6.2 percent of his or her salary still would be deducted to finance Social Security benefits. But in addition, that worker would be required to chip in an extra percentage point or two of salary to fund the Social Security supplement. So this plan gets its funding by adding to the current Social Security system.
Each plan has its pluses and minuses. The downside to an add-on plan is that more out-of-paycheck spending would be required from workers to fund their retirement portfolios. But the advantage to the plan is its greater rewards. Most "add-on" proposals are modeled after the highly successful Thrift Savings Plan, an add-on IRA that has been available to federal workers for years; it has given many of them the kind of financial security in retirement not usually associated with middle-class civil servants.
The upside to "carve-out" proposals is that no extra financial burden would be placed on young workers to finance the supplemental benefits. But the often unexplained downside is that huge reductions would be necessary in future Social Security benefits. It's just simple math. If you are going to carve out about one-third of the Social Security payroll tax to fund a worker's private supplement, then obviously future Social Security benefits for that same worker are going to have to be cut by at least one-third.
Apparently, the hope is that a well-managed private account would more than make up the difference. Also, carve-out plans come with huge transitional costs. Remember that Social Security is a "pay-as-you-go" program, meaning the money deducted from today's workers' paychecks is used to fund benefits to current retirees. So if you cut the amount of money going into the system, you must get funding from other sources to pay promised benefits to current retirees.
But here is the most important point I need to make about proposals for private accounts -- whether carve-out or add-on. Although they often are mentioned in the same breath as other proposals to "save Social Security," they do nothing of the sort. Social Security's long-range financing problems are the result of baby boomers quickly turning into senior boomers. For years, Social Security has been working extremely well with a ratio of three workers supporting one retiree. But by the time all the boomers retire (and that will be happening at a quickening pace over the next 15 years), there will be only two workers supporting each retiree. The system simply cannot work AS IT'S CURRENTLY STRUCTURED at a 2-1 ratio. To keep the system going beyond about 2030, either benefits will have to be cut or taxes will have to be raised. Private accounts would do nothing to affect either solution.
Tom Margenau's weekly column, "Social Security and You," appears at creators.com.